A policy exchange rider (often called a substituted insured rider or exchange of insureds option) provides that at the termination of the insured’s employment, a new key employee can be substituted as the insured under the original policy (assuming the new person can provide evidence of insurability). Of course, appropriate adjustments in premium, cash value, or face value are made to the policy reflecting differences in age or insurability between the original insured and the new insured. Typically, there is no additional charge by the insurer at the time the new insured is substituted nor are commissions paid to the agent at that time. For these reasons, the corporate owner of the key employee coverage saves both underwriting and commission costs and receives an actuarially equivalent policy on the life of the new key employee.
Unfortunately, to be protected by Internal Revenue Code section 1035, an exchange must be on the life of the same insured. So the substitution of one insured for another under a policy exchange rider on a corporate-owned key employee life insurance contract will be taxed as if the corporation sold the first policy and used the proceeds to purchase the new contract. The corporation will have to report gain at ordinary income rates on the difference between the fair market value of the policy at the time of the exchange and the net premiums it had paid to that date.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM